The entrepreneur walks on stage, does a brief pitch, and then tells the Sharks they are seeking X amount of money in exchange for Y percentage of their company. One of the sharks complains that this gives the company a current valuation that is far too high. Whether you’re swimming in the tank, attempting to raise funds from a venture capitalist, pitching to angel investors, or trying to get a little cash from friends and family, you should understand how the math works.
Imagine that you are partnering with a friend on a new venture. You invest $1000 and your friend invests $500. Since you invested 2/3 of the total, you should own 2/3 of the company. Since your friend invested 1/3 of the total, they will own 1/3 of the company.
It works the same way with an investor. Except in this case, instead of you contributing cash, you will be contributing the intrinsic value of the company. For example, if your company is worth $3M and you raise $1M, then you will have contributed 75% of the total value and will own 75% of the company.
To understand this better, you need to be familiar with the terms Pre-Money Valuation and Post-Money Valuation. Pre-Money Valuation is the value of the company prior to the investment and Post-Money Valuation is the value of the company after the investment. Since the only difference is the cash that is invested, the Post-Money Valuation is just the Pre-Money Valuation plus the amount of the investment. In the above example, the Pre-Money Valuation is $3M and the Post-Money Valuation is $4M.
Back to the tank. If the entrepreneur asks for $1M for a 25% stake in the company, then you might think that $1M is 25% of $4M, so the entrepreneur has valued their company at $4M. This is a good rough estimate, but is actually incorrect. $4M is actually the Post-Money Valuation. To get the Pre-Money Valuation you should deduct the $1M investment. So in this case, the entrepreneur has claimed a $3M Pre-Money Valuation. It is important to note that these formulas are only meaningful if the entrepreneur and the investor can agree on the pre-money-valuation, so these calculations really serve as the starting point for negotiation.
In an upcoming blog, we’ll discuss common methods for establishing a “reasonable” Pre-Money Valuation, in the hopes of avoiding the dismay often expressed by the sharks when they hear the entrepreneur’s opening pitch.